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Looking at profitability is a very important step in understanding a company. Profitability is essentially why the company exists and a key component in deciding whether to invest or to remain invested in a company. There are many metrics involved in calculating profitability, but for this article, I will look at BP PLC's (BP) earnings and earnings growth, profit margins, profitability ratios and cash flow.

Over the past 5 years the economy and subsequently energy prices have been hit hard. Through the above-mentioned four main metrics we will get an idea about the company's profitability over past 5 years. We will also get an idea how hard BP BPC was hit by the crisis, how the gulf spill affected the company financially and how well the company is recovering. By comparing this summary to other companies such as Chevron (CVX), and Exxon (XOM) who are in the same sector, you will be able see which has been the most profitable.

All material is sourced from Morningstar, and the Company webpage.

Earnings and Earnings Growth

1. Earnings = Sales x Profit Margin

  • 2010 - $302,545 billion x -1.22% = $(3.719) billion
  • 2011 - $386.463 billion x 6.65% = $25.700 billion

In looking at BP's 2010 earnings we can see the impact that the tragic accident that claimed 11 lives and injured many more on the Deepwater Horizon rig in the Gulf of Mexico had on the company. In 2010 the company spent $40.858 billion on "Gulf of Mexico oil spill response" which greatly affected the company's earnings in 2010. Due to the tragic events in the Gulf of Mexico in April of 2010, the company reported a loss of $3.719 billion.

2. Five-year historical look at earnings growth

  • 2007 - $20.845 billion, 39.54% increase over 2006
  • 2008 - $21.157 billion, 1.50% increase
  • 2009 - $16.578 billion, 21.64% decrease
  • 2010 - $(3.719)billion,
  • 2011 - $25.700 billion,

In looking at BP's earnings over the past five years, you can see how the economic crisis had an affect on the earnings in 2009. But in comparing the decline to its competitors such as Exxon who's earnings decreased by 57.36%, and Chevron who's earnings decreased by 128.28%, BP's earnings held up relatively well. Even though the earnings decreased by over 20 percent in 2009 the company still posted earnings of $16.578 billion.

In 2010, the earnings decreased to $-3.719 billion due to the gulf disaster.

In 2011, BP reported earnings of $25.700 billion which was above the previous 5 year peak of $21.157 billion reported in 2008.

Profit Margins

3. Gross Profit = Total Sales - Cost of Sales

In analyzing a company, gross profit is very important because it indicates how efficiently management uses labor and supplies in the production process. More specifically, it can be used to calculate gross profit margin. Here are BP's gross profits for the past two years:

  • 2010 - $302.545 billion - $280.826 billion = $21.719 billion
  • 2011 - $386.463 billion - $309.763 billion = $76.700 billion

4. Gross Profit Margin = Gross Income / Sales

The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

In reviewing BP's gross margin over the past five years, we can see the impact the financial crisis had on the company's sales, but we can also see that the margin held up very well. The 5-year low for the gross margin was reported in 2010 with a margin of 7.18% but the 5-year high for the margin was in 2009 with a margin of 21.82%. The 2011 gross profit margin of 19.85% was below the 5-year average subtract 2010, of 20.30%.

  • 2007 - $61.514 billion / $288.951 billion = 21.29%
  • 2008 - $68.653 billion / $365.700 billion = 18.77%
  • 2009 - $53.239 billion / $243.965 billion = 21.82%
  • 2010 - $21.719 billion / $302.545 billion = 7.18%
  • 2011 - $76.700 billion / $386.463 billion = 19.85%

As the gross margin is below the 5-year average this implies that management has been slightly less efficient in the company's manufacturing and distribution during the production process over the past 5 years.

5. Operating income = Total Sales - Operating Expenses

The amount of profit realized from the operations of a business after taking out operating expenses - such as cost of goods sold (COGS) or wages - and depreciation. Operating income takes the gross income (revenue minus COGS) and subtracts other operating expenses, then removes depreciation. These operating expenses are costs that are incurred from operating activities and include things such as office supplies and heat and power.

  • 2010 - $(4.825) billion
  • 2011 - $38.834 billion

6. Operating Margin = Operating Income / Total Sales

Operating margin is a measure of the proportion of a company's revenue that is left over after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs such as interest on debt. If a company's margin is increasing, it is earning more per dollar of sales. The higher the margin, the better.

Over the past five years, BP's operating margin has remained relatively the same with the exception of 2010. The 2011 operating margin of 10.05% is inline the peak margin of 10.94% reported in 2007.

  • 2007 - $31.611 billion / $288.951 billion = 10.94%
  • 2008 - $34.283 billion / $365.700 billion = 9.37%
  • 2009 - $25.124 billion / $243.965 billion = 10.30%
  • 2010 - $(4.825) billion / $302.545 billion = -1.59%
  • 2011 - $38.834 billion / $386.463 billion = 10.05%

The 2011 operating margin of 10.05% is slightly below the 5-year average subtract the 2010 margin of 10.16%. This implies that there has been slightly less of a percentage of the total sales left over after paying for variable costs of production such as wages and raw materials compared to the 5-year average.

7. Net Profit Margin = Net Income / Total Sales

A ratio of profitability calculated as net income divided by revenue, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings.

Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

Like the Operating Margin, BP's 2011 is below the 2007 peak net profit margin of 7.21% but the 2011 net profit margin of 6.65% is above the 5-year average minus 2010 of 6.61% .

  • 2007 - $20.845 billion / $288.951 billion = 7.21%
  • 2008 - $21.157 billion / $365.700 billion = 5.79%
  • 2009 - $16.578 billion / $243.965 billion = 6.80%
  • 2010 - $(3.719) billion / $302.545 billion = -1.23%
  • 2011 - $25.700 billion / $386.463 billion = 6.65%

As the 2011 net profit margin of 6.61% is above the 5-year average of 6.61%, this implies that there has been a increase in the percentage of earnings that the company is able to keep compared to the company's 5-year average.

The profitability margins are revealing a few different results. They are showing that over the past 5 years the company's profitability been very consistent despite the adversity that the company has had to endure. The company endured the financial crisis in 2008/2009, the subsequent crash in energy prices and the Gulf disaster in 2010. Despite these setbacks the company's margins have held up quite well.

In 2011 the company was able to withstand other tests regarding profitability:

We saw rapid and sometimes unpredictable change. This included escalation of the European debt crisis and political upheaval in countries where BP has significant operations, such as Libya and Egypt. We kept a close watch on these developments and acted where required. Our international advisory board assisted us in this task. (Company website)

As these variables have reduced the potential for profits, the company was still able to be consistent in maintaining its margins.

Profitability Ratios

8. ROA - Return on Assets = Net Income / Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."

Like the listed profitability margins, the 2011 ROA of BP PLC reveals very consistent results over the past 5 years. The 2011 ROA of 8.77% is above the 5-year average subtract 2010 of 8.48%.

  • 2007 - $20.845 billion / $236.076 billion = 8.83%
  • 2008 - $21.157 billion / $228.238 billion = 9.27%
  • 2009 - $16.578 billion / $235.968 billion = 7.03%
  • 2010 - $(3.719) billion / $272.262 billion = -1.37%
  • 2011 - $25.700 billion / $293.068 billion = 8.77%

As the 2011 ROA of 8.77% is above the 5-year average of 8.48%, this implies that management has been more able to use the company's assets to generate earnings compared to its 5-year average.

9. ROE - Return on Equity = Net Income / Shareholders' Equity

As shareholders' equity is measured as a firm's total assets minus its total liabilities, ROE reveals the amount of net income returned as a percentage of shareholders' equity. The return on equity measures a company's profitability by revealing how much profit it generates with the amount shareholders have invested.

  • 2007 - $20.845 billion / $93.690 billion = 22.25%
  • 2008 - $21.157 billion / $91.303 billion = 23.17%
  • 2009 - $16.578 billion / $101.613 billion = 16.31%
  • 2010 - $(3.719) billion / $94.987 billion = -3.92%
  • 2011 - $25.700 billion / $111.465 billion = 23.06%

Unlike the other margins and ratios, BP PLC's ROE has revealed a strong dip in 2009. In looking at the company's ROE over the past 5 years we can see that the ROE is up around same levels as 2007 and 2008. As the ROE is up from the 5 year average subtract 2010, this reveals that there has been an increase in how much profit has been generated compared to the amount that shareholders have invested.

Cash Flows

10. Free Cash Flow = Operating Cash Flow - Capital Expenditure

A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run.

Over four of the past five years, BP PLC's free cash flow has remained positive.

  • 2007 - $24.709 billion - $17.830 billion = $6.879 billion
  • 2008 - $38.095 billion - $22.658 billion = $15.437 billion
  • 2009 - $27.716 billion - $20.650 billion = $7.066 million
  • 2010 - $13.616 billion - $18.421 billion = $-4.805 billion
  • 2011 - $22.154 billion - $17.845 billion = $4.309 billion

Over 4 of the past 5 years BP PLC has had positive cash flow. This indicates that BP PLC has enough cash to develop new products, make acquisitions, pay dividends and reduce debt.

11. Cash Flow Margin = Cash Flow from Operating Activities / Total Sales

The higher the percentage, the more cash available from sales.

If a company is generating a negative cash flow, it shows up as a negative number in the numerator in the cash flow margin equation. This means that even as the company is generating sales revenue, it is losing money. The company will have to borrow money or raise money through investors in order to keep on operating.

As BP PLC's cash flow margin is positive, it does not have to take the above measures to continue operating.

  • 2007 - $24.709 billion / $288.951 billion = 8.55%
  • 2008 - $38.095 billion / $365.700 billion = 10.42%
  • 2009 - $27.716 billion / $243.965 billion = 11.36%
  • 2010 - $13.616 billion / $302.545 billion = 4.50%
  • 2011 - $22.154 billion / $386.463 billion = 5.73%

Summary

In looking at BP's earnings over the past five years, you can see how the economic crisis had an affect on the earnings in 2009. In comparing the 2009 decline to its competitors such as Exxon who's earnings decreased by 57.36%, and Chevron whose earnings decreased by 128.28%, BP's earnings held up relatively well. Even though the earnings decreased by over 20 percent in 2009 the company still posted earnings of $16.578 billion.

In 2010, the earnings decreased to $-3.719 billion due to the gulf disaster.

In 2011, BP reported earnings of $25.700 billion which was above the previous 5 year peak of $21.157 billion reported in 2008.

The profitability margins are revealing a few different results. They are showing that over the past 5 years the company's profitability been very consistent despite the adversity that the company has had to endure. The company endured the financial crisis in 2008/2009, the subsequent crash in energy prices and the Gulf disaster in 2010. Despite these setbacks the company's margins have held up quite well.

As these variables have tested the potential for profits, the company was still able to be consistent at maintaining its margins compared to its 5 year averages.

The ROA and ROE indicate similar results in that both the ROA and ROE are showing similar results as the profit margins.

With free cash flow and the free cash flow margin both displaying positive cash, BP PLC has enough cash to develop new products, make acquisitions, pay dividends and reduce debt without having to borrow or raise money to maintain operations.

The analysis of BP PBL's profitability indicates a strong company that has been tested over the past few years. Even with the adversity that the company has been through over the past couple of years, the trends show strong signals for the future as BP PLC has a strong amount of free cash at hand, which means the company will likely continue to grow for the foreseeable future.

Looking forward,

Energy demand is linked to economic growth, development and population. The world's population is projected to increase by 1.4 billion over the next 20 years, while its real income is likely to grow by 100% over the same period.

This combination of factors is expected to increase world primary energy consumption by approximately 40% over the next 20 years, with non-OECD energy consumption as much as 70% higher by 2030. Energy and climate policies, efficiency gains and a long-term structural shift in fast-growing economies away from industry towards less energy-intensive activities may act to restrain consumption, but the overall trend is likely to be one of strong growth in energy demand. (Company Website)

Analysts are predicting cautious growth over the next couple of years, as they are estimating EPS for 2012 at $5.65 and an EPS of $6.13 for 2013. (MSN Money)

For more information on BP PLC, read my article: Analyzing BP's Debt And Risk and

Source: BP PLC's Profitability Analysis